What is a Discount Rate and Why Does It Matter?

Pensions often seem confusing because there are a number of technical details associated with them. While actuaries and economists may enjoy debating the finer points of these technical matters, most workers and retirees just want to know if their pension is going to be there when they need it. However, one question we’ve gotten is: what is a discount rate and why does it matter?

A discount rate is a term in economics related to the present value of future payments, in this case, pension benefits. The present value of a pension benefit is how much it is worth today. If the worker contributes $100 and the employer contributes $100, then the present value of the pension benefit, as of today, is $200. Now, $200 may not sound like very much, which is why pension funds invest the contributions they receive from employees and employers, so that those contributions can earn interest and gain value over the course of an employee’s career. That $200 invested today will be worth substantially more in 30 years at the end of the employee’s career. In fact, economists predict how much that $200 will be worth in 30 years using an assumption about how much that money will grow over time.

By their nature, estimates of future value are imprecise. If the economy and stock market do really well, that $200 could gain a lot of value over 30 years. On the other hand, a recession like the one in 2008 could erase much of the interest gained over 30 years. However, pension plans need to make an assumption about future investment earnings, so they can assess how much they need in contributions from employees and employers in the upcoming year. The discount rate is used to allocate the cost of future benefits over time, to answer the basic question “how much should we contribute today so we hit our funding target in the future?” Most public pension plans use a discount rate between 7 percent and 8 percent (the average is 7.6 percent).

Why does all this matter? Because some anti-pension ideologues have started attacking the discount rate used by public pension plans as a way to attack pensions. Chief among them is Stanford economist Josh Rauh. For years, Rauh has promoted the idea that public pension plans are using an assumed discount rate that is too high. He wants them to use a rate that is much lower. The reason you should care is because if the assumed discount rate is lowered, then it makes pensions appear to be more expensive because you are assuming that the pension fund will earn less money over time, meaning more money needs to be contributed now for the pension benefits that will be paid out in, say, 30 years.

Over the long term, public pensions have met, or exceeded, their investment target goals. They will experience year-to-year fluctuations, but over 25-30 years, the plans will usually meet their goals. In fact, one study found that the 25 year median investment return for public pension plans was 8.3 percent, higher than the assumed investment return. By using an interest rate that is unreasonably low, Rauh is creating the impression that pension funds are far worse off than they are. His so-called studies are then picked up and passed off as evidence in the political arena to justify closing pension funds down.

Since 2008, many public pension plans have already lowered their assumed discount rate to account for the slow recovery from the financial crisis. Over the past quarter-century, public pension plans have exceeded the assumed rate of return on their investments. This has enabled them to deliver on the promise of a secure retirement to teachers, firefighters, and other public employees across the nation.

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